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Model behavior. Nothing artificial.

NEW TECH CAN HELP FIRMS
MODEL THEIR DATA

To tap into the value of data, companies are increasingly
turning to machine learning and artificial intelligence (AI).

As hardware, processing power and storage capacities have rocketed into the stratosphere, so has companies’ ability to solve complex, real-world business problems through the application of machine learning/AI techniques and algorithms.

In the financial services industry, however—one of the most data-rich industries in the world—companies have so far only begun to foray into the rich world of machine learning and AI.

WHO DO YOU TRUST?

A key impediment to the adoption of machine learning and AI is how to trust a particular model or algorithm—a point consistently posed to banks by their regulators as well as their own internal control functions.

The ability to explain the conceptual soundness and accuracy of such techniques is a significant challenge, not only because the tools are so new, but also because there is an inevitable “black box” nature of some of the more powerful machine learning and AI approaches.

Two related but distinct challenges are involved here:

Challenges in model validation:
Banks will remain subject to scrutiny focused on the development and execution of statistical and analytical tools following industry guidelines or their own standards and protocols.

Challenges in model risk management:
The challenges of using machine learning and AI models extends to the larger discourse on model risk management. Management of this risk can be seen as an array of the source of model risk (data, estimation and usage) against the measurement (identification, quantification and mitigation).

WHAT’S DIFFERENT?

Compared to traditional model validation, machine learning and artificial intelligence will differ in the areas of data, processes, methodology and governance:

More complex algorithms and model development processes are harder to document

Methodology

Measures of fit or discrimination may have different interpretations than in traditional techniques

Greater emphasis on out-of-sample performance and stability metrics

Governance

Challenging to design policies and knowledgeable governance of more complex development, monitoring and use

Addressing these challenges with new validation techniques can help raise the level of confidence in model risk management. It can also raise the confidence of regulators in the accuracy and appropriateness of emerging machine learning and AI tools in areas such as credit risk and regulatory capital management, stress testing and trade surveillance.

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